Will the Debt Bubble Burst in 2019?

23 January 2019

One of the unintended, albeit unsurprising, consequences of the current period of ultra-loose monetary conditions has been the extraordinary buildup in debt worldwide. The top Chart illustrates that during the previous business cycle global debt had remained stable at what seemed an elevated level of 80% of GDP.  In the aftermath of the Global Financial Crisis (GFC), however, world-wide debt has surged to nearly 220% of GDP (all data in this report refers to the non-financial sector only). Both the public and private sectors have contributed to this situation. Governments employed fiscal stimulus during the Great Recession, and corporations (and households in some cases) found the historically low interest rates irresistable.

The recent widening of corporate credit spreads have led investors to question whether a bursting debt bubble could contribute to a global recession in 2019.  Will a loss of market confidence lead to dramatically higher corporate borrowing costs, tighter financial market conditions, and a global slump? As the debt buildup has occurred world-wide, where are the risks greatest?  As I suspect global inflation will be lower than expected this year, continued loose monetary conditions should reduce the likelihood of a crisis in 2019.  Although this will be small consolation to credit investors, as credit spreads will widened further.  However, the high debt burden will take its toll on the world’s long-term GDP growth potential during the next decade. And, as global growth decelerates further next year — including a 40% risk of recession — the risk of the debt bubble bursting in 2020 will grow.

USA: End of Easy Money Exposes the Risks

The Chart above illustrates the sharp increase in US debt: rising from 180% to 250% of GDP during the past two decades. The good news is that the ratio has stabilised in the past few years. And, as the following Chart shows, US debt remains slightly below other advanced economies (where the debt load totals 270% of GDP).

Trends in total debt, however, hide more than they reveal. For instance, excessive personal sector borrowing was at the epicenter of the GFC.  But, successful deleveraging has led to a sharp decline in households’ debt burden since 2008. With disposable income rising and consumer confidence high, this sector is unlikely to provoke the next crisis. However, it is worth noting that US household debt remains both above earlier levels, and exceeds other advanced economies (77% versus 72% of GDP).

The earlier Chart illustrates the key role the government sector played in the spiraling US debt — as public sector liabilities have doubled as a share of GDP (now 100%). Again, the government’s debt burden has stabilised in recent years, despite the Trump Administration’s tax cuts in 2018. However, as the economic boost from the fiscal stimulus fades, the American budget deficit will expand to 5% of GDP in coming years.  In the absence of  fiscal belt-tightening — actually, additional spending on infrastructure seems more likely — US public sector debt will again rise, increasing towards 115% of GDP by 2025. Future out-sized budget deficits will add  to America’s debt balloon, and pose risks to global markets, especially as the US central bank unwinds its balance sheet.

The Federal Reserve has paid considerable attention to the sharp rise in corporate debt. The earlier Chart illustrates the secular increase in business borrowing over the past few decades. And, after a brief pause, corporate debt is rising again, and exceeds the peak level of the previous economic cycle. Furthermore, the Fed highlights the deterioration in the credit quality of borrowers.   The Chart above illustrates the increased share of High Yield and BBB (lowest investment grade rating) borrowing. During a recession much of the new BBB debt could be downgraded to junk status, which investment grade investors would need to sell. Furthermore, high-risk, leveraged loan borrowing also has surged recently.

The Fed and others have observed that corporate debt has risen much faster that capital spending both recently and over the medium term (Chart above). This indicates much of the borrowing has been used to buy back equity and boost dividends, and raises concerns about debt servicing during the next economic downturn. By the way, the same has happened in Europe.

To be sure, these trends are worrisome, but one should not panic, at least not yet! First of all, there is no consensus about the optimal level of corporate debt. And, even after rising for decades, US business sector liabilities remain lower than in other advanced nations: 74% versus 90% of GDP (see earlier Chart).

In addition, while borrowing has risen sharply, US corporate performance has been healthy. The combination of solid earnings growth and low interest rates has allowed firms to comfortably service the debt load, as well as accumulate an enormous amount of cash. The Chart above illustrates that compared to profits (EBITDA),  the level of net debt (gross borrowing less cash) is not particularly elevated. Likewise, the debt servicing metric (EBITDA/Interest) is not especially onerous. Likewise, at the same time as gross debt has been rising, the value of corporate assets on their balance sheets has increased also. The following Chart shows that while firms’ debt/asset leverage ratio has risen, it is not way out of line with historical norms.

We now know what to might trigger a bursting of the debt bubble: rising budget deficits, weaker corporate profits, higher interest rates, declining asset values,  lower cash levels. Sounds a bit like the 2019 outlook! The Fed’s recent indication that they have become more flexible about further interest rate hikes near term should buy time, but the ingredients for volatility in the credit markets are falling into place!

Europe: Troubles Ahead, Eventually!

Europe has experienced the same buildup of indebtedness, and has benefited even more from the period of very low interest rates. As in the USA, corporate and government borrowing have risen sharply, while consumers have reduced debt (Chart above).  As a result, total debt as a percent of GDP exceeds the USA: 260% compared to 250%.

Following the GFC and Euro Crisis, government debt rose sharply — from 65% to a peak of 110% of GDP.  Years of austerity have succeeded in reducing the public sector debt ratio during the past few years. Currently, Europe now runs a primary surplus (overall deficit less interest payments) of 1.2% of GDP, which is roughly in line with the region’s long-term GDP growth potential. As a result, the debt ratio will continue to decline as long as real interest rates remain negative. Going forward, public discontent with austerity (as expressed in the rise of nationalist, populist political movements)is likely to lead to more stimulative fiscal policies. Therefore, as European interest rates eventually normalise, debt ratios will head up again (Germany excepted), especially if GDP growth slumps.

As in the USA, meanwhile, Europe has experienced a secular increase in corporate borrowing. During the past two decades, business debt has risen from 70% to 106% of GDP, which is significantly higher than the USA at 74% of GDP.  The following Chart, however, highlights a high degree of variation within the region. German debt, for example, is relatively low (55%). Corporations in the former Crisis PIIGS have all reduced borrowings dramatically, and Spain, Italy, and Greece now have debt metrics below the region’s average. The same is true in the United Kingdom.  On the other hand, France (as if Macron did not have enough problems), Belgium, Switzerland, and the Scandinavian countries have high and rising levels of business indebtedness.

As in the USA, households are unlikely to be a major factor in the coming debt drama. Indeed, European personal borrowing is considerably lower than in the USA (58% of GDP versus 77%). Again, there are exceptions. Low interest rates have fueled mortgage lending and sharp rises in housing prices in Switzerland and Scandinavia, along with Australia, New Zealand, and Canada. Signs of property bubbles have emerged in these markets, creating risks as interest rates normalise.

Emerging Markets: China and External Debt

As in the developed economies, the emerging market nations found the allure of cheap money too enticing to pass up. As a result, overall borrowing as a percent of GDP rose from 110% to 175% of GDP since 2008. Nevertheless, total EM debt remains well below their DM counterparts (which stands at 270% of GDP); however, the gap is narrowing. Household and government debt are much lower in the emerging markets, while corporate debt levels are becoming more similar.

Two key themes describe the buildup of EM debt since the GFC. First of all, China has been the dominant borrower during the period. To be sure, corporate borrowing has risen significantly in many EM nations, especially Turkey, Brazil, and Russia.  However, China accounted for 82% of total EM debt accumulation since 2007! In an earlier blog “China: Slowdown Just Beginning”, I discussed how China’s deleveraging would lead to significantly slower GDP growth (approaching 5%) for several years. As most of China’s debt is owed to local banks, the vulnerability of the global economy emanates largely via weaker Chinese growth prospects.

The second key development was  the appetite for external borrowing in certain EM countries. Turkey and Argentina last year highlighted the potential risks to financial markets of large-scale foreign borrowings. We discovered that countries with sizeable amounts of short-term external debt, combined with overvalued exchange rates and low policy credibility, were the most vulnerable (see Chart above). Following last year’s turmoil, most of the most exposed countries now have significantly undervalued exchange rates. With the Federal Reserve adopting recently a more dovish policy approach, I do not expect a replay of last year’s EM volatility in 2019. Indeed, EM FX offers several attractive opportunities. Even in Turkey and Argentina, where credibility remains low, the deeply discounted currencies are likely to appreciate (at least in real terms).

Strategic Implications
  • Rising US budget deficits, slower GDP and EPS growth, and higher interest rates will produce greater volatility and wider spreads in US corporate credit markets. While a dovish Fed reduces the likelihood of a full-blown crisis near term, risks will escalate as the economy slows further in 2020.
  • Europe’s ultra-low interest rates have allowed the region to sustain a debt stockpile that’s even larger than America’s. However, weak GDP growth and the EU’s failure to introduce pro-growth reforms will add to risks as interest rates normalise in coming years.  However, as I do not expect the ECB to raise interest rates this year, the day of reckoning may be delayed.
  • Debt deleveraging will be a headwind for China for several years. GDP growth will slow towards 5% over the next two years.  Stimulative monetary policy may impede the process, which could  make the inevitable adjustment more painful.
  • A dovish Fed should create opportunities in several deeply undervalued Emerging Market currencies this year, especially if policy credibility can be restored.
  • Monetary policy normalisation could curb housing bubbles in Scandinavia, Switzerland, several English-speaking countries.